The Rise and Fall of Speculative Stocks Explained
While overall equity returns were unremarkable in January, speculative trading in a few stocks was electrifying. As investors focused on traditional measures of company and economic health, such as earnings and economic growth, momentum drove several names to unusually high levels. We asked Seth Hieken, Director of In-House Solutions and Senior Portfolio Manager about the peculiar market activity.
You’ve discussed how the combination of free trading, free money, free time, and social media have fueled speculation in the market. Can you expand on that a bit?
Let’s take these in order:
- Free trading – The watershed move by Charles Schwab in 2019 to eliminate commissions on trades opened the door for other custodians to follow and for retail investors to trade with unlimited frequency. There were an estimated 10 million new retail accounts opened in 2020. There are echoes of 1999 in the explosion of activity, when discount brokers such as Ameritrade rushed to slash commissions to attract day traders.
- Free money – With interest rates near zero and the Fed pledging to keep them there, the opportunity cost to invest has been nil. The massive Cares Act stimulus package also served as fuel, putting checks directly in bank accounts. A good deal of this cash could not be spent with much of the economy shut down, leaving the stock market as a beneficiary of inflows.
- Free time – With lockdowns in effect, a new generation of investors had plenty of time on their hands to trade. Other avenues of speculation or entertainment such as sports or casino gambling were inaccessible, leading some to turn to stocks.
- Social media – Armed with full wallets, frictionless trading, and flush with near term success, this new generation of traders increasingly took to sharing ideas on social media platforms such as Reddit and Discord. Their voices could be amplified in a way that granted them market power that small investors never before experienced; their ideas could go viral.
There is a narrative that these traders were “taking down Wall Street” by “squeezing the shorts.” What does that mean?
There seems to be something of a political or class aspect to the trading, with the retail message boards and blogs symbolizing a populist call to arms against the old–line Wall Street institutions. The targeting of companies with enormous short interest was clever and, for a period, created a feedback loop that impacted more than just the hedge funds who are required to buy back the shares that they had borrowed at higher prices. Moreover, trading in the option market forced dealers to buy the underlying shares and increased the margin risk to the firms that supported the retail trading. Retail traders may have “won the battle” against a few hedge funds last week; we’ll likely have to wait a few more weeks or months, however, before we see who really “wins the war.”
There are a handful of stocks that have been targeted: GameStop, Blackberry, and AMC. They have been good stocks over the last few weeks, for sure, but what do you think about the companies?
What these three all have in common is:
- a large number of shares sold short, i.e., shares borrowed by investors and sold in anticipation of buying them back in the future at a lower price; and
- business models that are under severe pressure, ostensibly the rationale for short sellers.
Market prices usually reflect the flow of information surrounding companies and the environment in which they operate, allowing investors an opportunity to decide to buy, sell, or do nothing. Occasionally, however, prices become disconnected from reality, and instead represent emotional reactions. The mechanics of short selling, combined with various other factors we discussed earlier, have allowed the prices of these issues to run amok. We know how similar episodes in history have ended – badly.
What has “ended badly” meant in the past?
Although this generation wouldn’t recognize the pets.com sock puppet if it were performing in their backyard, there are clear echoes of 1999 in some of the individual stock action. A recent WSJ Streetwise column referenced K-Tel, the then-dying purveyor of essentials like the Veg-O-Matic, that announced it was taking its business online. That set off a short squeeze that sent the stock up tenfold in less than a month but did not prevent the company’s ultimate demise. Anyone who jumps on board one of these rocket ships now should expect a very rough re-entry to reality.
If you were mentoring someone beginning to play the market for the first time, what advice would you give them?
Any business is ultimately worth the Discounted value of its Cash Flows (DCF). If price deviates wildly north of that estimation of value, buying is speculation, not an investment. There is nothing inherently wrong about speculating, but you need to recognize it as such and limit the amount of your capital at risk to avoid catastrophe. You should always have a rationale for any stock you purchase, and if you find yourself needing to change that rationale to justify holding it, it is probably time to sell.
If you are looking for an acronym that creates longer-term, sustainable wealth – forget YOLO and FOMO, and focus on DCF.
Note: The stocks referenced in this article are not held by any TCG equity strategy; they were chosen based on their recent headlines and are not recommendations to invest in any particular security.